Professor Hubert Fromlet Linnaeus University / Sweden
Summary:
Policy and Politics in the EU/EMU and China ‐ Some Neglected Aspects
Presentation at the International Conference of the GIC (Global Interdependence Center, Philadelphia) in Milan/Italy, May 15‐17, 2013 The current growth problems of the EU/EMU and China’s important role in keeping global growth roughly on the expected track frequently top the headlines. On the other hand: we are not sufficiently informed about, for example, the problems of the Chinese financial system and total government debt. Thus, markets neglect this important issue. We know, however, quite a lot about this kind of problem when it comes to Europe. In this presentation I would like to focus on a number of phenomena that are or may become important in the foreseeable future ‐ but which so far have not received the necessary attention when it comes to major economic/financial analysis.
EU / EMU: ¤ Changes in the political landscape ‐ the end of solidarity? One of the main problems of the EU/EMU is the lack of visions for the future. National interests dominate. “Free riders” like Sweden behave to a great extent like outsiders, fearing public skepticism and future punishment in general elections. The same pattern can be observed in other countries. Solidarity and common visions/objectives are more or less gone. This whole phenomenon raises the question of policy sequencing. Does the EU/EMU first need political leaders who create the strategic model for the political future of Europe? Or should it be the other way around, i.e. solving the most acute problems and then getting back to the remaining long‐term issues in a couple of years? An optimizing combination of both approaches seems to be impossible any time soon since the gap of interest between “the north” and “the south” of the EU/EMU area remains too wide.
¤ The German elections ‐ the most neglected political European risk? It may happen that the forthcoming German elections this fall and the outcome of this important event may turn out to be an extremely underestimated risk for Europe and the financial markets. The re‐election of chancellor Merkel appears to be very uncertain. The destiny of the current government’s junior coalition partner, the FDP, remains unclear. Furthermore, a new party (the AfD, “Alternative for Germany”) with an anti‐EMU orientation ‐ although not necessarily anti‐EU ‐ was founded quite recently. AfD is a party that gathers particularly many euro opponents from less realized academic and certain populist camps ‐ without having any real comprehensive program for the future of Germany. It should be added, too, that Germany’s social democratic opposition is now intensifying the election campaign by arguing for higher taxes ‐ just as their most probable coalition partners, the Greens, do ‐ which would particularly hit SMEs. Such a policy change would definitely not favor economic growth ‐ and reminds us to some extent of the frustrating French example. Sure, the concrete political risks in Italy, France and some other countries may be considerably higher ‐ but possible future German political developments may currently be the most neglected ones on the European risk horizon.
¤ Is the German economy overestimated? Germany is generally regarded as the anchor of European economy. This is certainly true. It should be asked, however, whether Germany’s economic fundamentals and trends really meet current positive mainstream expectations for the future. Sure, Germany’s industry is very competitive. In contrast to the situation during other longer periods in the past decades, current German unemployment seems to be (somewhat) less challenging. It should also be mentioned that Germany’s fiscal outlook is starting to look more favorable than could have been foreseen two or three years ago. But there is a flipside to the German economy as well. One can still find a substantial number of institutional shortcomings. Many of the more recently created jobs are poorly paid or part‐time. The insufficient number of kindergartens prevents many women from entering or continuing in the work force. Regional disparities are still far too large, an issue which is partly related to the insufficient performance of economic growth. Too many players on financial markets are not really aware of the fact that the potential GDP growth in Germany has decreased to around 1.3 percent which must be interpreted as quite disappointing. Of course, the German economy looks much healthier than the economic conditions in all the other larger EMU countries indicate. But the remaining German weaknesses also clarify that cannot afford higher taxes and other policy adventures that may follow next fall’s elections.
¤ German foreign investments are underperforming One more negative and neglected topic with German nexus is Germany’s poor investment performance in other countries. Value losses in the past few 7‐8 years are enormous ‐ according to the research institute DIW in Berlin approximately EUR 650 billion when putting together portfolio
and real, more long‐term oriented investments; by the way, the U.S. has been much more successful in this respect. I’m not sure how financial markets will react once this development becomes more widely known. The other question is whether this poor performance ‐ which certainly to a large extent has been driven by the crisis in Southern Europe ‐ will lead to more risk aversion by foreign investors in Germany itself and by German investors abroad.
¤ The probable enlargement of the euro in 2014 ‐ and why it should not take place In this context, I am talking about another country that wants to join the euro as soon as possible, probably already next year. Latvia thinks that it has met the criteria for making such a step. In this context, however, we should make a distinction between meeting convergence criteria for entering the euro in the aftermath of a deep recession or during longer growth periods on trend or above trend. After a couple of years of a serious recession and austerity, the Latvian economy is now growing again in a more satisfactory way. But what will happen in a couple of years’ time when the efforts of the internal devaluation will gradually decrease or fade? Where are the sources for future value‐added in production and exports in order to give the current account balance more fundamental stability? When will wages have a greater damaging effect on inflation again? Where is the financial room for maneuver when it comes to more concentration on upgraded educations efforts? To sum up: Latvia’s intended joining of the euro in 2014 ‐ which is expected to be approved in a couple of weeks from now ‐ may turn out to be clearly premature. Structural improvements have to be checked for sustainability for at least another five years or so before entering the EMU. This should imply that the Latvian lats (LVL) should be placed on the waiting list for entering Euroland at least until the end of this decade.
¤ High public debt in many European countries ‐ but what about private debt? Private debt has become really high in a number of European countries, Sweden included. This is a widely neglected topic. Markets are not really remembering historical experience.
China: ¤ The transition of power and the search for new political legitimacy: Three months after the shift of political power in China, one of the main questions should concern the political legitimacy of the Xi Jinping/Li Keqiang leadership. For the previous four post‐war political generations, the answers were quite logical (Mao: the establishment of the Communist regime, Deng: the introduction of the new reform and opening‐up policy, Jiang: the broader practical implementation of Deng’s new approach and strong economic growth, Hu: continuing strong
economic growth and the more effective and visible introduction of China into the international arena). In my view, Xi and Li will face extremely difficult legitimacy problems which is, for example, reflected by the contradictory objectives of high economic growth and the environment. These issues are briefly addressed in the next chapter ‐ i.e. the large numbers of conflicts of goals of economic and social policy.
¤ The large number of conflicts of goals China is an ambitious country that would preferably like to optimize high GDP growth with low inflation, a healthy development of credit and a balanced asset price market ‐ but also a major improvement in the environment. Many more such conflicts of goals could be mentioned ‐ some of them I will return to below. All these conflicts are tough to handle ‐ which should happen already in the next few years! I have a distinct feeling that the policy challenges for Xi and Li will be much tougher than those of their predecessors. This means that financial analysts should also look much more deeply into Chinese politics than obviously has been the case in the past ten to fifteen years.
¤ Marketization and transparency vs. political influence Here we come to one of the least observed and analyzed future challenges so far ‐ and one of the most important strategic risks for Chinese political leaders in the forthcoming years. The whole issue concerns the maintenance of political power and political influence versus better structures in the economy ‐ better structures which at the same time would assume losses of political power. An example: Both further noticeable increases of marketization and more (economic) transparency would lead to gradually reduced political power.
¤ The total (local) government debt conundrum Guestimates of the real size of Chinese government debt vary considerably. Direct central government debt may be around 20 percent of GDP which is in line with mainstream guestimates. For local debt, however, the range of guestimates is very wide: from more cooling levels of officially 30‐35 percent up to the worrisome, hot areas of 100 percent or so (see my paper published by BOFIT online, i.e. the Bank of Finland, March 2013). Currently markets don’t observe China’s debt numbers very closely because of the ongoing current account surplus which means that no net borrowing abroad is needed. If this important advantage were to be fundamentally reversed one day ‐ for example at the end of the current political leadership ‐ things would look different and could make markets very, very nervous. Furthermore, the issue of total Chinese government debt is also related to further economic reforms ‐ deregulations on financial markets and transparency very much included ‐ and the possible transition(s) to other future currency regimes. These kinds of nexus are usually not considered in the economic analysis of China.
¤ The realistic options for Chinese exchange rate policy China these days adopts an exchange rate system that I ‐ without adhering to IMF terms ‐ would like to define as “strictly managed floating” rather than using the official definition expressed as “managed floating exchange rate based on market supply and demand with reference to a basket of currencies” ‐ since the composition of this basket is still treated as a state secret. Daily fluctuations have been widened one year ago to 1 percent in either direction. According to a recent survey by Linnaeus University, free convertibility of the RMB should be at least 10 years in the future. Within the coming years, only two policy options can be regarded as applicable: ‐ either a working basket policy (which should assume transparency about the weights of the basket currencies and a loss of political influence) or ‐ a continued “strictly managed floating system” ‐ with only a gradual and very cautious transition to more market‐determined exchange rates (and pretty strong maintenance of political influence on exchange rate decisions); the option of a markedly faster introduction of a cleaner free‐floating system should be regarded as too risky from a Chinese political perspective ‐ also when considering the associated need for faster financial cross‐border deregulation (which is not really desirable). In this whole context, the important issue of sequencing should not be neglected. Preconditions may change, but the sequencing for getting to a (more or less) floating exchange rate should and currency convertibility may look as follows ‐ with a time horizon of probably at least ten years (but who knows?): ‐ first, a major modernization of the Chinese banks and the whole financial system should take place; ‐ second, the point mentioned above should also include the bond market in order to make monetary policy more effective; ‐ third, transparency of financial markets should be increased substantially; ‐ fourth, financial cross‐border deregulations should happen from a position of economic strength and satisfactory social and political stability (see R.McKinnon, S.Edwards, J‐P Agénor); ‐ fifth, loosening credit controls should be handled very carefully and as a very late ‐ or the last ‐ step of the whole process towards a convertible and freely floating Chinese currency.
¤ Insufficient analysis by financial markets ‐ but also insufficient statistical information Analytical knowledge of global financial analysts about the Chinese economy still seems to be insufficient in many cases. This includes knowledge of shortcomings in Chinese statistics. Otherwise, visible reactions of financial markets to smaller deviations from expected statistical outcome would be negligible. This should be said despite a number of statistical quality improvements that have taken place in the past few years. Consequently, it is impossible to feel really well informed on the current state of the economy. As far as the current slight slowdown is concerned: is it in line with reality or is the deceleration of growth (somewhat) stronger than shown in the first quarter (7.7 percent)? It seems to be impossible to have a sophisticated answer to this question. Hubert Fromlet / Linnaeus University/Sweden